CAKE: THE PARTY IS OVER, FOR NOW

Takeaway:We still like the company, a lot. But, short-term pressure in the casual dining industry is forcing us to take a step back.

We are removing CAKE from the Hedgeye Best Ideas list as a LONG.

Getting Out of the Way

We remain extremely cautious on the casual dining segment and are not comfortable being long the name heading into the 3Q13 print.

In addition, its looks like industry sales trends are off to a slow start in 4Q13, which leads us to believe it could be a disappointing fourth quarter.

A couple of weeks ago, we posted a research note highlighting the bull case for CAKE. To be clear, it remains one of our favorite casual dining names and we plan to revisit it on the long side when the time is appropriate. Our call is more about a tumultuous casual dining environment, and the potential short-term pain it could cause, than it is about the company itself. In fact, we would not be comfortable being long any casual dining names heading into earnings season. If you need to be long something, we suggest looking to the quick-service segment, where we continue to like CMG, YUM and KKD.

The chart below highlights the correlation between the ICSC US Retail Chain Store Sales Index and CAKE’s comparable restaurant sales. As depicted, the ICSC Index ticked down in 3Q and this trend has continued into 4Q. According to Consensus Metrix, CAKE’s comparable restaurant sales in 3Q and 4Q are expected to increase +0.4% and +1.7%, respectively. We believe these estimates are too high and should come down.

Also, we’d be remiss not to note – the slowdown in sales we are seeing in the early part of October coincides with lower consumer confidence numbers, as reported by the daily Gallup confidence reading.

Howard Penney

Managing Director

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10/15/13 03:36 PM EDT

DARDEN: A GENERATIONAL OPPORTUNITY?

Energy: Maintaining the MLP Space

This week Hedgeye Energy sector senior analyst Kevin Kaiser hosted an expert call with Richard Kuprewicz, an energy industry expert with over forty years’ experience as an engineer in the oil and gas industry. Mr. Kuprewicz consults to government agencies and NGOs worldwide, as well as to public and industry bodies, on pipeline regulation, operation and design, with particular emphasis on operation in unusually sensitive areas of high population density or environmental sensitivity.

Video of Kaiser discussing Kinder Morgan

Mr. Kuprewicz discussed the current state of long-haul oil and natural gas pipeline maintenance in the US today and its implications for investors in energy MLPs. If you have been following Kaiser’s work on the MLP space, you know he considers the amounts of money spent – or not spent – on maintaining pipeline integrity (“maintenance capex”) is a key to determining whether management is acting responsibly in the interest of the shareholders and society.

Regulation

Oil and gas pipelines are regulated under the US Department of Transportation’s Pipeline and Hazardous Materials Safety Administration (PHSMA) and its “Integrity Management Program.” The IMP focuses on minimal safety requirements to prevent pipeline rupture. There is no specific spending requirement or set of action steps associated with the IMP. Instead there are what are called “process steps” which assume the operator will pay attention to integrity of its pipelines and specific risks associated with unique conditions. This applies particularly to what PHSMA defines as “high consequence” geographical areas – defined by potential danger to human population, or to the environment. Kuprewicz says that many companies routinely provide “high consequence” level oversight throughout their system. And then, some don’t.

The IMP was instituted about 10 yrs ago. Kuprewicz says PHMSA rulemaking is just a First Step in a process that will take many years to unfold. By itself, Kuprewicz says the IMP standard is not sufficient to impose high safety standards across the industry.

Practical Implications

Kuprewicz says PHMSA regulatory enforcement is “mostly reactive,” rather than relying on extensive inspections. He says the agencies involved in pipeline oversight are surprised at the large number of operators who “don’t get the fundamental concept of Integrity Management,’” pointing to a number of serious pipeline ruptures in recent years. Kuprewicz says many of these companies have over-complicated the regulatory process, creating reams of internal documentation about the IMP, but not actually implementing its principles.

Operators are frequently not audited – luckily for them, says Kuprewicz, since many would not pass. Pipeline operators enter their pipeline integrity data into the PHMSA database under a one-way process: the operator can enter the data, but PHMSA can not change it. This means that when operators enter erroneous data – or even fraudulent data – it remains in the record.

Some pipeline operators focus on visible problem areas, leaving most of their pipeline unattended and exposed. “Common sense tells you most of the maintenance cost is in the pumping and compressor stations,” says Kuprewicz, but the highest actual risk is on the miles and miles of main line. A compressor station breakdown will lead to a shut-down. But a main line rupture can have serious consequences, including potential massive loss of life.

Kuprewicz says that age of a pipeline is not the best indicator of risk of rupture. If properly maintained, he says carbon steel pipe essentially has no “useful life.” Well-maintained pipe can last “forever” he says, citing pipelines that have been in continuous operation for a century. Kuprewicz says the accounting practice of taking depreciation on carbon steel pipeline, generally over a 50 or 60 year “useful life,” does not reflect reality.

Of course the key is proper maintenance, including periodic replacement of segments that show signs of stress or other risk factors. Kuprewicz says the key to proper maintenance is the operator’s ability to accurately identify and assess the specific risks to their pipeline, often segment by segment. This makes it logical that the IMP requires “proper maintenance,” rather than specifying spending levels. However, it effectively leaves oversight of the operation to the operators themselves. Conflicts arise in the MLP sector, where the primary business of the entity is often not producing or transporting oil and gas, but rather making increasingly large periodic cash distributions to the unit-holders. One obvious way to increase cash in the till is to not spend it on incidentals such as maintaining one’s pipeline.

Risk Factors

An operator’s definition of “acceptable risk” may be very different from yours, especially if you or your loved ones live in a “high impact area.” Operators, like other business executives, calculate “risk” in terms of projected cost. Over time, failure to provide adequate ongoing maintenance makes pipeline ruptures both increasingly likely, and increasingly unpredictable. An operator that doesn’t put up serious maintenance capex is also not likely to do ongoing assessment to identify specific risks throughout their network. Thus, big regulatory changes are almost always brought about by major ruptures that are often both tragic and extremely expensive.

A more recent problem spreading throughout the industry is the lack of reliable records, particularly pipeline maintenance records and risk assessments. Many oil and gas companies have gone through mergers in recent years – indeed, the MLP space continues to be driven at least partly by an ongoing strategy of buying operating properties or companies in order to distribute their cash flow. In the wake of a transaction, the inefficient merger of cultures can lead to chaos. As management focuses on getting control of costs, one place they always look is to the back office. Kuprewicz says a surprisingly large number of merger or acquisition transactions have resulted in managers ordering the destruction of critical records as cost saving measure.

A related risk is the loss of the expertise of older employees. Professionals with 30 or 40 years’ experience are retiring. In an M&A scenario these employees are frequently offered – or forced into – early retirement, with the result that both the industry expertise and critical knowledge of the corporate culture walk out the door and are not adequately replaced. Rather than having older seasoned employees mentoring younger ones, the new hires step right into positions with real operational and decision-making responsibility. Kuprewicz says a number of companies have repeated mistakes they made ten and twenty years ago, sometimes with dire consequences.

Finally, Kuprewicz touched on the phenomenon known as “gold plating,” where some operators spend ostentatiously – often in the aftermath of a major tragedy. “I used to think a billion dollars was a lot of money,” mused Kuprewicz, “until I saw the way some of these operators throw money around” to cover their tracks after a major pipeline rupture. This creates the illusion that the company cares, that management is taking the situation seriously, that it has actually addressed the problem. But these “gold plating” exercises often do not dig down to the fundamental question of why the process broke down, of how the operator lost control of the pipeline.

Cost cutting tends to lie at the root of many pipeline problems and is associated with most breakdowns. Complex organizations tend to focus more on senior management directives to cut costs, and less on engineers in the field who say more resources are needed to address specific risks. Says Kuprewicz, costs decline linearly, but risks rise exponentially. This ends up in literally in a “bet the company,” scenario. Kuprewicz says he does not see a sector-wide tendency on the part of MLPs and other operators to make reckless decisions. Still, when there are massive tragedies, he says there’s nearly always someone in senior management beating the big drum to cut costs.

Risk Managed Long Term Investing for Pros

Critical Quant Signals, Holding

The U.S. Dollar is holding its long-term TAIL risk line of $79.21 support. And the 10-year U.S. Treasury is holding its 2.58% TREND line. Both are critical quantitative signals that matter in my model.

Don’t forget: The sovereign debt bubble is just as glaring as the Gold bubble was.

Jones: What Next for Twitter?

“The most dangerous leadership myth is that leaders are born - that there is a genetic factor to leadership. That’s nonsense; in fact, the opposite is true. Leaders are made rather than born.”

-Warren Bennis

We’ve started our work for our October 31st IPO Blackbook on Twitter and digging into a company that was founded in 2006 and already has 215 million monthly users. Talking about going viral in a hurry!

Similar to Facebook, Twitter has that little problem of how to make money. That attribute aside, the companies are very different, even if much of the conventional media puts them in the same category. Facebook is a true social network and, as such, is largely closed and limited in terms of how large a network it can become. On the other hand, Twitter is open, transparent, real-time and has scale.

Twitter is actually a true network in that it creates the network effect. As an example, when President Obama announce his victory in the 2012 election on Twitter, that Tweet was re-tweeted more than 25 million times. The most I’ve ever had a tweet re-tweeted was a couple of hundred times, but even there you get the point. Twitter amplifies your communication.

Analyzing Twitter has also made me consider the importance of leadership in corporate America. This weekend The New York Times Magazine had an article written by Nick Bilton that was titled, “All Is Fair in Love and Twitter.” It is one version of the power and leadership struggles that have occurred within Twitter.

Twitter is also a little bit about the American dream. Take this excerpt from the article for example:

“In 2005, Jack Dorsey was a 29-year-old New York University dropout who sometimes wore a T-shirt with his phone number on the front and a nose ring. After a three-month stint writing code for an Alcatraz boat-tour outfit, he was living in a tiny San Francisco apartment. He had recently been turned down for a job at Camper, the shoe store.”

Dorsey and his co-founders have been largely pushed out of Twitter, though many of them will obviously profit handsomely on the IPO. Time will tell whether current CEO Dick Costolo is the right man to monetize the Twitter network, but his experience at Andersen Consulting, founding and running Feed Burner (among other start-ups), and working at Google have allowed him to acquire learned leadership assets, to Bennis’ point, that will be critical for Twitter’s future.

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